Halloween indicator turned on its head

Commentary: Pity the poor investors who sold in May

In reaching new all-time highs in September, stocks defied their seasonal tendency to produce mediocre returns between May Day and Halloween.

Fortunately, though, this doesn’t necessarily mean that stocks will buck another well-worn trend: their penchant for doing well between Oct. 31 and the following May 1.

If this past May Day you did what followers of this seasonal pattern recommend — to “sell in May and go away” — you therefore should be focusing in coming weeks on getting back in.

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You might be given an especially good opportunity to do so if the market falls in the wake of continuing political paralysis in Washington over the budget and the debt ceiling. So far, though, the market has managed to hold its own since the government impasse began on Oct. 1, largely on the strength of this past Tuesday’s strong gain. The market suffered significant declines on both Wednesday and Thursday.

This “six-months-on, six-months-off” seasonal pattern, also called the “Halloween Indicator,” refers to the marked tendency for the stock market to turn in the bulk of its gains between Oct. 31 and the subsequent May 1.

Over the past 50 years, for example, the S&P 500
SPX, -0.88%
has gained an average of 6.6% during those months. Between May 1 and Oct. 31, by contrast, its average gain has been just 0.8%.

This stark difference isn’t a fluke, according to Ben Jacobsen, a finance professor at Massey University in New Zealand. He found strong evidence of the Halloween Indicator after analyzing the stock-market histories of 108 countries for as far back as data were available.

“While it may not be present in all countries all the time, it most often is,” Prof. Jacobsen says.

Though researchers aren’t sure why this pattern exists, Prof. Jacobsen suspects it can be traced to the summer vacations of traders and investors in the Northern hemisphere.

The stock market has defied these odds over the past six months. At its all-time high last month, for example, the S&P 500 was 8.3% higher than where it stood on May 1. Even with the market’s pullback over the past two weeks, it remains 5.1% higher.

It isn’t unprecedented for the stock market to fly in the face of the poor seasonal odds and rise during the summer months, of course. But it doesn’t happen very often: There have been 15 occasions over the past 50 years when the S&P 500 gained as much during the summer as it has this year.

Yet in those years when it has done so, that strength has tended to persist into the subsequent winter period — resulting in an average S&P 500 gain of 9.6% between Halloween and May Day six months later. That is higher than the winter gains following losing summers: Over the past 50 years, the S&P 500’s average gain in such periods was 5.3%.

To be sure, the six-month unfavorable period isn’t yet over, and it isn’t out of the question that the next few weeks could see a decline that leaves the stock market lower on Halloween than where it was this past May Day. But notice that, even if that does happen, the stock market still has decent odds of gaining in the six months thereafter.

Those who built up a lot of cash this past May because of this seasonal pattern should therefore be looking to get back in.

Investors who precisely follow the Halloween Indicator will, of course, wait until Oct. 31 to reinvest the cash they raised this past May Day. But several of the investment advisers monitored by the Hulbert Financial Digest believe you can improve on the indicator’s returns by searching for a different day during October or November on which to do so.

The adviser who has had the greatest success doing this is Sy Harding, who edits a service called Sy Harding’s Street Smart Report. He follows precise rules for when to get back into stocks using a short-term-momentum technical indicator known as the Moving Average Convergence Divergence, or MACD. It is based on a complicated formula relating the 12-day and 26-day moving averages of the market and is widely available at most financial websites, including The Wall Street Journal and Marketwatch.

According to Harding’s rules, in no event should investors get back into stocks before Oct. 16, since he has found through back-testing that, before mid-October, the unfavorable seasonal tendencies usually are so powerful that they outweigh even an MACD buy signal.

If the stock market is in the midst of a strong short-term rally on that date — and the MACD is therefore showing a buy signal — Harding will get back into stocks immediately. Otherwise, he waits until that indicator triggers a subsequent buy signal. He uses the inverse of this approach when getting out of stocks in the spring.

Consider a hypothetical portfolio that, using Harding’s method, switched between the Wilshire 5000 index
W5000FLT, -0.79%
, which reflects the performance of the entire U.S. stock market, and 90-day Treasury bills. This portfolio would have gained 8.5% annualized over the past 12 years, according to the Hulbert Financial Digest, assuming dividends were reinvested.

That is better than the 6.9% annualized produced by the original, unmodified version of the Halloween Indicator, which in turn is better than the 6.2% return of simply buying and holding the stock market. Better yet, Harding’s portfolio was completely out of the market half the time, so it incurred only half the risk. That is a winning combination.

Harding says he expects the market at some point this month or next to be sufficiently lower than where it stands now to make it worthwhile for clients following the Halloween Indicator to wait before getting back in. When he does recommend that clients get back in, he says he will tell them to buy the so-called Dow Diamonds — the SPDR Dow Jones Industrial Average exchange-traded fund
DIA, -1.01%
, which has an annual expense ratio of 0.17%, or $17 per $10,000 invested. He says he recommends this ETF because the seasonal pattern is most pronounced among blue-chip stocks.

Prof. Jacobsen says that the Halloween Indicator also is quite strong in Europe, and in the United Kingdom and France in particular. One inexpensive ETF that provides exposure to all of Europe is Vanguard FTSE Europe, with an expense ratio of 0.12%.

Two ETFs benchmarked to the stock markets of the individual countries are iShares MSCI United Kingdom
EWU, -1.69%
and iShares MSCI France Index
EWQ, -1.52%
. Both have an expense ratio of 0.53%.

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